Four indicators that demonstrate the contrarian UK stock market opportunity
If it pays to be greedy when others are fearful then now may be time to consider increasing exposure to UK shares
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The FTSE 100 may be scaling new all-time highs, but unlike in Japan, where the Nikkei 225 recently achieved the same feat, few commentators are talking about a turning point. The UK equity market remains in a sorry state if you believe the headlines.
With sentiment so low though, contrarian investors might argue things can only get better. Legendary investor Warren Buffett once remarked that it’s wise for investors to “be fearful when others are greedy and greedy when others are fearful”.
As ever, Buffett has been busy eating his own cooking. He invested heavily in Japanese stocks a few years ago when many commentators were writing off the stock market. And he’s been rewarded handsomely for it.
The Nikkei 225 – which tracks Japan’s largest companies – is the best performing major index year-to-date (at least in local currency terms). Could UK equities be at a similar position to where Japanese ones were two years ago, and about to take off?
Equity investing always carries risks and trying to time shifts in markets is far from being an exact science. That said, here are four contrarian indicators which underline how bad sentiment has become, and so how large the potential opportunity might be.
Contrarian indicator #1 – dearth of IPOs
A dearth of new companies coming to the market, or initial public offerings (IPOs) may not be helping the mood of investment bankers given the lack of juicy fees.
History clearly shows, however, that increased UK IPO activity typically corresponds with a short-term peak in the equity market – witness the high levels of IPO activity in 2008 and 2021, compared with current depressed levels.
Contrarian indicator #2 – low valuations right across the market
Valuations are also extremely attractive across the entire size spectrum of UK companies (see chart, below).
Hence the pick-up in “incoming” bids from overseas competitors and private equity acquirers for FTSE 100 and small and mid-size companies, such as constituents of the FTSE 250 index.
Foreign bidders are clearly seeing the opportunity to secure attractive assets and market positions at knock-down prices.
Contrarian indicator #3 – rock-bottom pension ownership
Domestic pension funds are increasingly mature and have reduced allocations to volatile equities in an effort to better manage their liabilities.
Data from the UK’s Office for National Statistics shows that domestic pension funds now own just 1.6% of the UK equity market compared with around 33% back in the 1990s.
Meanwhile, the Capital Market Industry Taskforce, a cross industry group looking at ways to reform the UK equity market, estimates the domestic equity allocation is 2.8% (see table, below).
On either measure, domestic ownership is low relative to other territories.
Nobody has a crystal ball regarding exact timing, but it’s hard to see that domestic pension funds can significantly further reduce their exposure to UK equities.
And what’s to stop a new government from mandating a certain minimum level of UK equity exposure within pension portfolios, following on from the current administration's belated and rather half-hearted announcement of a British ISA?
It seems that something needs to be done to encourage long-term investment in UK-listed companies.
If action is taken at some point, we may see increased demand at a time of limited supply (see contrarian indicator #4, below). This would be good for asset prices and hence returns for patient UK equity investors. Time to be greedy.
Let’s not forget either that demand from private UK investors is hardly sky-high either.
Many of those individuals who got rich on the back of “Tell Sid” privatisations and demutualisation of building societies between the 1980s and early noughties switched their allegiance to technology-heavy equity markets overseas.
We’re constantly asking ourselves what might cause them to reappraise these allocations.
Contrarian indicator #4 – shrinking UK stock market
On the issue of supply, more confident management teams are buying back shares at a very rapid clip (see chart, below).
Additionally, some UK companies are looking to relist their shares in the US (attracted by a potentially bigger pool of capital and higher valuations), and that’s not even mentioning those companies set to be lost to bids.
Again, less supply when demand may be set to increase – it may be time to get greedy.
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